Skinned in the Game

Banks, once burned, have pushed back successfully, so far, against a perverse Dodd-Frank rule requiring that they retain 5% of the risk of mortgages they originate. What's at stake for the industry, and for the feds.

Thank You

Error.

The 848-page Dodd-Frank Act overflows with abstruse rules that have profound consequences, but attract little public attention. One such rule requires banks to keep at least 5% of the risk of the mortgages they originate, instead of passing it all off to buyers of securitized mortgages. Co-sponsor Rep. Barney Frank (D., Mass.) explained the theory: If banks have skin in the game, "we'll just get better-quality loans."

Regulators published a 97-page proposed rule in the Federal Register in April 2011 to implement the risk-retention requirements. Bankers lobbied against the proposal, arguing that it would retard the securitization of mortgages, deprive the housing industry of funds, and impede an economic recovery. Regulators retreated. A year has now gone by without a final rule.

Good riddance to the rule, but not because it would have hurt housing. Forcing banks to retain risks is unwarranted. Along with most other provisions of Dodd-Frank, it constitutes regulatory asphyxiation. Smothering the Federal Deposit Insurance Corp., the Securities and Exchange Commission, and the Federal Reserve with ambiguous new responsibilities for curing minor or imagined nuisances makes it impossible for regulators to focus on their crucial tasks. Worse, the rule would help perpetuate the excessive conversion of old-fashioned bank loans into tradable securities.

Maintaining the soundness of banks should be the regulators' job No. 1. The banking system requires good and well-enforced rules to counter its inherent fragility. Just as traffic on unpoliced roads is chaotic, even if most drivers are naturally law-abiding, unregulated banks tend to implode, even if most bankers are inherently prudent.

Dodd-Frank constitutes regulatory asphyxiation. Fortunately, Congress has yet to impose one of the act's more perverse rules: a requirement that banks retain a portion of their mortgage risk.
Stuart Goldenberg for Barron's

When little else was regulated in the 19th and early 20th centuries, lawmakers kept banks on a tight leash. Even so, we didn't get all the pieces of bank regulation right until the 1930s. In contrast, the securities markets functioned adequately under the private rules of the stock exchanges.

We can argue about what kind of regulatory model is best—whether or not deposit insurance should be capped, for instance. But skin-in-the-game rules that require banks to take on more risk are perverse.

Banks were vulnerable to the collapse of the housing and mortgage-backed securities markets in many ways. They had financed the inventory of mortgages that had not yet been turned into securities and invested heavily in the securities themselves. Providers of wholesale short-term funds shunned mega-banks exposed to derivatives based on mortgage-backed securities.

These problems arose from risks that banks had taken on, not ones they had palmed off to investors.

The seemingly arcane 5% rule also raises another basic public-policy issue: Why single out investors in mortgage-backed securities for protection? Bonds issued by rock-solid companies can also become nearly worthless. Think of the formerly rock-solid General Motors and American Airlines. Stocks of high- or low-tech companies often crater.

According to Barney Frank's reasoning, forcing underwriters to retain some of the risk should improve the quality of corporate securities as well. Yet, with uncommon good sense, Congress hasn't imposed such a requirement.

MORTGAGE-BACKED SECURITIES should be less deserving of lawmakers' solicitude. Corporate bonds first were widely issued in the 19th century by railroads that had to raise more funds than a single lender could advance. Utilities and industrial companies with similarly large capital requirements followed. But even a small community bank can make and hold mortgages; securitization isn't compelled by the scale of the activity financed. The economic advantages of securitization supposedly derive from efficiencies in the financing process, in the mass-production and mass-marketing of credit.

Mass production in turn entails the use of backward-looking statistical models that pay no heed to the specific circumstances of the borrower. This virtually ensures bad credit decisions in a dynamic economy in which the demand for loans starts with the forward-looking judgments of aspiring borrowers.

Traditional corporate bonds aren't meant to be mass-produced, although they may be mass-marketed to public investors. Good underwriting requires careful forward-looking assessments of each issuer's prospects.

The securitization of mass-produced mortgage credit surged before the 2008 crash because public policies and officials inflated what would otherwise have been a fringe activity.

Banks have had to set aside less capital against investments in securitized mortgages than they do for their direct holdings of mortgage loans. This has encouraged banks to try to raise their return on equity by replacing loans with securities.

Banks and other investors in mortgage securities could also eliminate the costs of monitoring borrowers, relying instead on the ratings provided by SEC-certified agencies.

Public officials averred that securities comprising geographically diversified mortgages were perfectly safe. And not long before the housing bubble burst, Ben Bernanke said that a nationwide decline in home prices was unlikely.

Most mortgages have been securitized by government-sponsored entities, virtually guaranteeing investors a free lunch: higher interest than paid by Treasury bonds but with practically no more risk.

Guaranteeing housing debt was instrumental in discouraging careful lending. It drew credit away from more worthwhile borrowers and activities, even before the crash.

The housing and securitized-mortgage markets remain weak. Instead of trying to pump them back up, lawmakers and regulators must focus relentlessly on recreating a banking system that lends prudently and evenhandedly to all creditworthy businesses and individuals.

AMAR BHIDÉ, the Schmidheiny Professor at Tufts' Fletcher School of Law and Diplomacy, is the author of A Call for Judgment: Sensible Finance for a Dynamic Economy (Oxford University Press, 2010).